JCL Blog

Today in the Wall Street Journal, Goldman Sachs calls for more regulation and says everyone should support IEX, the new exchange started by Brad Katsuyama and featured in Flash Boys by Michael Lewis.

The article references in internal email that says:

"While we think that a regulatory response may be needed to address these market structure issues, it would be best for the overall market if IEX achieved critical mass, even if that results in reduced volumes in our US dark pool, Sigma X."

It took forever, but it finally happend. Back in 2010 I wrote this post saying that more regulation would not happen on Wall Street until the Wall Street guys decided it would be good for them. At the time I thought that they would want it because individual investors would be leaving the market. Any maybe that is why they are calling for it now.

Another potential motivation comes out in Flash Boys however. Goldman Sachs is way behind the other high frequency traders. This could be because they cannot get or keep good programming tallent -- because they got the FBI to jail one former employee. They also show their neaderthal tendencies when they refuse to participate in the open source community and proclaim all open source code to be proprietary to them. So they were losing to the other scammers -- what a perfect time to call for more regulation.

I suppose I should not be surprised that five years into the financial crisis that nothing has really changed in the way that the financial markets work. Either way it is disappointing that our economic system, arguably the most adaptable, has not adapted. The explanation: no change will come until it is really needed (forced on us).

My thought then was that Goldman Sachs and the other market manipulators would eventually want real regulation because they would need it to get customers to come back. Imagine if we had as little confidence in the FAA as we do in the SEC -- Amtrack might have a viable business!

It now seems like such a polylanna-ish thought that we would ever be able to overcome the influence of Goldman Sachs and the other insiders.

Our real "problem" is that the rest of the world is in worse shape than we are, and everyone wants to park their cash in the US. So in the end we only have to be less corrupt than the alternatives to avoid making changes.

Michael Lewis is one of my favorite authors. His magic is the ability to rapidly become an insider on a subject, without losing the perspective of an outsider. He is an Earthling that sees the world through the eyes of a Martian. Or a bond trader that sees Wall Street through the eyes of main street. His latest work, Boomerang, takes us on a tour of what he is calling the new third world. This is great irony capitalizing on the recent fashion of using the term “developing nation” instead of the term “third world”. It is no longer correct to count the worlds. Counting or not, we have leap frogged in the backward direction - over the developing nations. His tour of countries worse off than the third world starts in Iceland, and goes to Ireland, Greece, Spain, Germany, and well, California.

The recurring theme is examining what people do when told they are in a room full of money and: “The lights are out, you can do whatever you want to do and no one will ever know.” It’s a great mental picture that takes all of a half second to absorb. Lewis makes it even more powerful by applying it to nations. “Americans wanted to own homes far larger than they could afford, and to allow the strong to exploit the weak. Icelanders wanted to stop fishing and become investment bankers, and to allow their alpha males to reveal a theretofore suppressed megalomania. The Germans wanted to be even more German; the Irish wanted to stop being Irish…”

The section on Germany was particularly interesting as Lewis investigated that culture’s fascination with human waste, which made them particularly vulnerable to the toxic waste products being packaged by our people on Wall Street. It will be a long time before anybody anywhere in the world ever trusts Americans again. WMD + Abu Ghraib + Goldman Sachs = Americans are liars. Our reputation could not be repaired even if we had the money to do another Marshall Plan. Looks like we are going to be sewing Canadian flags on our backpacks for many years to come.

There have been many great reviews of the book. Here are links to a few of them:

The Economist last week recalled a vivid description by Rolling Stone of Goldman Sachs: "a great vampire squid" that likes to stick its "blood funnel" into anything that can make it money. So given all of the advantages that Facebook has, why would a smart guy like Mark Zuckerberg subject himself to a bleeding by the many tentacled machine of Wall Street?

Maybe Zuckerberg knows that there are bad guys in the world and bringing in the firm that is the best at aggressively pursuing its own self interest will equip Facebook to fend off the other bad guys. In essence, a deal with the devil. Who are the these bad guys? One of Facebook's biggest shareholders is Digital Sky Technologies (DST), the firm of Alisher Usmanov, a Russian oligarch with ties to Vladimir Putin and Dmitry Medvedev. Even executives with ten times Zuckerberg's experience would be worried when considering how to control DST. With Goldman at the table could the dynamics of the relationship between Zuck and the Russians be improved?

If that is not enough incentive, there could be a bigger one right here in the USA. Goldman Sachs may be good at the things it talks about on its web site, but they really shine when it comes to manipulating our government. And Facebook needs all the help they can get controlling the US government. Twitter disclosed last week that the government had requested access to data on Julian Assange and people associated with him. To Twitter's credit they chose to disclose this request to the public. We can be sure that similar letters were sent to Facebook, Google, and other service providers. But we did not hear a word about those.

It is a little spooky thinking about government agencies combing through Facebook data, but we can be pretty sure that Facebook's nearly 600 million users, their relationships with other users, and all of the interactions between them must be irresistible to our many law enforcement and counter terrorism groups. I know that if I had to figure out how to deal with the FBI or CIA, not to mention the SEC, having Goldman's muscle to back me up would be quite welcome.

Well it has been a year and this is my 272nd post. I set out to write a blog entry every day and even though I came up a few short, I have enjoyed organizing my thoughts and working on my writing in 2010.

Thinking about why I do what I do, or what I plan to do in the future is unavoidable (for me anyway) as the calendar changes to a new year. The blog posts I wrote this year were adequate notes to myself about what I was thinking at the time, and the fact that 4,000 other people found my posts interesting enough to read is flattering.

So what to do in 2011? I have no plans to become a journalist, so I am not looking for a scoop or to break a story. I do think I could put more effort into some bigger writing pieces that further organize my thinking into actual arguments. So in the weeks ahead I am going to pick a few main themes and start to develop them into longer essays that argue a particular point.

Here are some possible subjects based on the number of entries I made this year organized into broad categories:

Tech Marketing (113 entries): I write a lot about this because my company helps large tech companies with sales and marketing. I think the changing role of the salesperson is worth spending time thinking about with Google and Facebook on one end of the spectrum because they really have no salespeople, and Salesforce.com on the other end spending 50% of revenue on salespeople. I don't know how this is going to work out but it sure will be interesting to watch.

New Media (51 entries): My second most written about topic is new media. To me New Media is the decline of the newspaper, publishing, and TV we grew up with and the rise of blogging, micro blogging, social media, and streaming media over the Internet. We live in a very interesting time and the creative destruction of this sector is one of the things that makes it so interesting.

Politics (47 entries): Next in line is politics - mostly in the US, but invariably overlapping with the rise of China as a world power. The big question of course is whether or not the US will stay on top and how many wars will we start as we struggle with our identity.

Economics (44 entries): Finally economics. In the world I want to live in, those that create the most value get the most rewards. It does not take long to see that right now getting rewarded is often disconnected from value creation. Will my pollyannaish view of the world find its way into reality, or will Goldman Sachs continue to gobble up everything for themselves?

There is one other subject that I find very interesting and that weaves throughout all of this: demographics. We often define people in groups and evaluate the relationships between the groups based on our understanding of the average within that group. This tendency prevents us from seeing the real picture. The growth rate of a nation's GDP or even the GDP per capita does not tell us very much. The unemployment rate in the US is around 10% -- but some sectors cannot find enough workers and others have 25% unemployment. If you are interested in this subject, read this from Foreign Affairs. Sure there are well over a billion people in China, but half of them are subsistence farmers who do not participate in the economy.

I am looking forward to digging in on these topics during 2011. As always, your comments and thoughts are appreciated.

Life is governed by the laws of physics, the laws of nature, and the rule of the mob. Physics is "what goes up must come down". I don't know what the laws of nature are, but we say they have been violated when we see something really disturbing, so I am sure they are useful. And the rule of the mob is about to take down two companies we thought were invincible just a few months ago: Goldman Sachs and Facebook.

There are undoubtedly books on the rule of the mob and I have not read any of them. My description goes like this: when a person or an organization gets to the top of the heap, it has to spend so much energy just staying at the top of the heap, that it cannot stay on the top of the heap any longer. The timing of the process is highly variable, but the faster one gets to the top of the heap the more likely the mob will vigorously pursue a change in the hierarchy.

Goldman Sachs got there slowly and stayed at the top for a very long time. Most of us cannot even remember a time that Goldman was not at the top. SEC Chairman Mary Schapiro was quoted in the Wall Street Journal on Saturday saying "If we don't get serious about this process, we may cease to exist." Goldman may own parts of the government, but this kind of resolve will be hard to overcome. Who would you pick for longevity, the SEC or Goldman Sachs. I go with the SEC.

Facebook blew past 300 million users to its current 500 million or so and its founder has turned down hundreds of millions of dollars to keep running it. The tide is turning however and it is now cooler to quit Facebook than to use it. The tech community turned against Facebook several weeks ago, and the rest of the mob will likely defect in the weeks ahead. In fact there is a web site dedicated to this movement called Quit Facebook Day.

One interesting element to these actions by the mob is the lack of viable alternatives. Goldman Sachs is probably not any more evil than any of the other firms on Wall Street. Their unique crime is that they are just so good at taking their client's money. Clearly market demand for a system we can use to organize our relationships on the web has driven Facebook to its current heights. No clear successor has presented itself, although the mob is putting some weight behind the Diaspora Project, but four kids with an idea does not a viable alternative make.

If you are Mark Zuckerberg, or Lloyd Blankfein, you can be comforted to know that the crowd will only take you down a few notches and probably not out of the picture all together. After all, your predecessors put you in good company. Firms like Standard Oil, IBM, and Microsoft all fell victim to the mob.

We fly because of the FAA is doing its job. The FAA exists because the airlines want it to. We invest on Wall Street even though we know the SEC is not doing it's job. Besides proof that greed is more powerful than fear as a motivator in the financial markets, and visa versa for travelers, this shows us that until the financial firms want to be regulated (and call off their dogs in DC), there will be no meaningful financial regulation.

There are a few simple things that the individual investor can do to influence this situation:

Sell your stocks

Influence the institutions (it worked with divestiture from South Africa)

Tell everyone why you are doing it.

Once such an exit from the markets gets going, others will follow if for no other reason than self preservation. Which will drive the markets down further.

Once wall street realizes they need regulation to rebuild trust in the markets, then financial reforms will come easily.

The first to advocate for regulation will be the honest firms -- after all, the guys who were maintaining their airplanes before the FAA had to pick between skimping on maintenance (to be competitive) or advocating for regulation to make the other guys maintain their planes. I don't see any financial firms advocating for regulation yet -- so maybe none of them are honest!

What to do with your money if you take it out of the market? Check out my recommended portfolio allocation here.

Anyone who has been through lifesaving class knows that a drowning person, in an effort of self preservation, will try to save himself by pushing you under. Goldman Sachs could be drowning and we should be on the lookout for GS to try to save itself by grabbing anyone nearby. We saw the first evidence of this last week when an attempt was made to implicate Warren Buffet. Anyone in finance faced with drowning would pick Buffet as a good place to find some buoyancy.

Deflecting to the system is another defense that Goldman is almost certain to invoke. So watch for the everyone was doing it/ if you arrest us you have to arrest everyone defense.

We should expect this same dynamic to play out in other areas where titans are threatened. After all, the mightiest do the most amazing things to hang on to their power, and the most desperate things on the way down.

I would also put Facebook, Google, Apple, and maybe even China in the category of titans.

Former treasury secretary Robert Rubin had to pick between admitting incompetence or confessing to corruption this week and instead he declared that knowing Citi Group was out on a dangerous ledge was not his job. Since he was paid 100 million dollars to advise Citi on something, and since he was at one time the CEO of Goldman Sachs (who invented the complex instruments that caused the crash), what was his job?

The only explanation is that Citi was buying inside access to Washington from Rubin - not his wall street expertise. So this week Robert Rubin was telling the world that his job was to ensure that Citi was not regulated. So I believe him when he says it was not his job to know what was on the balance sheet -- it was his job to make sure no one in the government knew either.

Here is a piece from November 2007 with some of the details about the things Rubin was not watching.

Here is a piece from October 2008 where the NY Times looks into the work Rubin did with Alan Greenspan to discredit Brooksley Born, who at the time was running the Commodity Futures Trading Commission, and who was advocating greater regulation of derivatives.

We ended up giving Citigroup 45 billion dollars -- so Rubin earned his pay. He got each citizen of our country to give Citigroup $150 in bail out money. His next trick? Maybe his job now is to figure out how not to pay it back!

Michael Lewis just put out another book about Wall Street - the topic that originally made him famous when he wrote Liars Poker in the '80s. Readers of this blog know that I am already a fan (see Moneyball and The Home Game) and The Big Short does not disappoint.

Knowing that I am not going to get another new work by this author for a year or so, I did my best to pace myself, but it was hopeless and three days later I was done. Even though I am familiar with the story (see Too Big to Fail) I was not tempted even once to skim.

In a strange way the book restored some of my confidence in our free market system because the people that the author chooses to follow in the book are small time outsiders who were able to figure out very early what was going to happen in the market for mortgage bonds. Simultaneously however, Lewis reinforced my view that the Wall Street game is rigged and only a fools expose their money to parasites like Goldman Sachs.

Here are my take aways:

The people at Goldman Sachs really are the best and the brightest -- and they really are amoral. They invented the complex instruments that caused the problem, made the fees, and promptly offloaded the risks to others -- like AIG. They did their very best to conceal the truth by influencing everyone from the ratings agencies to the government -- which permitted the problem to get very big before it blew up. I can't help but wonder how many other times the economy got wobbly and was prevented from behaving like a self correcting rational market because Goldman and others like them were madly pulling all of the levers to maximize their winnings.

Our government has no idea what to do about it. Clearly the regulators are being deceived and worse yet they don't know it. They were nowhere to be found while Bear Stearns, Lehman Bros, AIG, and others were placing gargantuan bets with other people's money and, amazingly, enough of their own money to blow themselves up. When it came time to assess the situation and decide about TARP there was not a single government official that really knew what was going on.

The author makes an effort to get to a root cause and drills to the Solomon Brothers conversion from a private company to a public company and therefore shifting the risk of their activities away from themselves and to their shareholders. Everyone of John Gutfreund's peers considered it a betrayal at the time, but they all eventually followed suit. Once they had suckered others to bear the risk -- they cranked the compensation models in their own favor and the RTC/Junk Bond blow up, the Long Term Capital Management blow up, the latest melt down, and the next catastrophe were set in motion.

That is right, we have not fixed a thing and just as the insiders are on their way to their next really big payday, the rest of the country is on its way to another "surprise" on Wall Street. If you have a hard time believing this, check out this article in the Guardian about David Tepper. Tepper decided he was not being fairly compensated at Goldman Sachs -- so he started Appaloosa Management that bet big on the government bailout of the banks. His fund is up $4.5 billion and he gets $2.5 billion of it. I wonder what is going to happen when the size of the problems created on Wall Street exceeds the financial capacity of our government to pay the bill. Will we call that financial armageddon?

It took a while but I finally finished Too Big to Fail. This is a big book about the 2008 financial melt down and bankruptcy of Lehman Brothers. The author does an amazing job of taking us through events in 2008 that we have already heard so much about. He makes the book work by recreating the conversations between the players in such a lifelike way that you feel you are there. Sure he did a great deal of research -- but part of me has to think there was a fair amount of artistic license taken. Even so I highly recommend the book and I have a much better understanding of our financial system and these events from reading it.

Key take aways:

When you hear "That will never happen" -- look out! Ten years earlier the geniuses at Long Term Capital Management were saying that about interest rates, and this time it was real estate. Who knows what it will be next time, but when the markets start to think that naturally occurring cycles are no longer occurring naturally -- go to cash fast.

Henry Paulson is not as bad a guy as I thought. The then Treasury Secretary was on the top of my list of corrupt people before reading the book and by the end I came to the conclusion that he was not such a bad guy. Even so we would be fools to think his bias towards Goldman Sachs was completely neutralized -- clearly his being there helped that firm.

Goldman Sachs is a truly remarkable firm -- not so much remarkable as in good but remarkably good at what they do. And what they do is take care of themselves. Their tradition of sending their retired leaders to Washington is pretty smart. They were also smart enough to see the water draining out of the system and made repeated significant efforts to protect themselves -- both by using their influence and raising mountains of capital.

Street fighters like Dick Fuld of Lehman Brothers are not well equipped to make it through a catastrophe like this credit crisis. His major weakness was his long string of successes fighting against everyone and prevailing. It left him with no friends and no way to see the truth in what was happening.

The people in the government are at a distinct disadvantage. The smartest ones have ties to their former firms so they can't really be trusted to look out for the public and the ones without wall street experience don't really know what is going on.

In the end the point of the title comes out. The only way we are going to solve the many problems of our financial industry is to figure out how to make sure no one is Too Big to Fail. The author does not address that in the book.